**Calculate the actual amount of consumption, in nominal dollars,**

**using the stated assumptions.**

Finance – Consumption Problem using real & nominal

rates

5.1 Assume you have $1 million now, and you have just retired

from your job. You expect to live for 20 years, and you want to

have the same level of consumption (i.e., purchasing power) for

each of these 20 years, after adjusting for inflation. You also

wish to leave the purchasing power equivalent of $100,000 today to

your kids at the end of the 20 years as a bequest (or to pay them

to take care of you).

You expect inflation to be 3% per year for the next 20 years,

and nominal interest rates are expected to stay around 8% per

year.

A. Calculate the actual amount of consumption, in nominal dollars,

using the stated assumptions.

i. How much do you need for your kids?

ii. If you plan to consume $1.03 in year 1, how much will you need

to have to keep the same real consumption in year 2? In year 10? In

year 20?

Inflation is expected to run at 3% per year for the next 20

years.

iii. How much, in nominal dollars, will $1 of retirement

funds earn in year 1? Year 2? Year 10? Year 20?

The nominal rate of interest is expected to run at 8% per

year.

iv. In an Excel spreadsheet (or in a manual table), calculate the

following:

a. annual investment earnings for each year

b. total savings after investment earnings for each

year

c. subtract annual consumption from total savings each

year

d. by trial and error, or with the Goal Seek command, determine the

amount of consumption that will give you exactly $100,000, in

today’s purchasing power, at the end of 20 years

Hint: You will need to make your annual consumption column

dependent on the inflation rate, your investment earnings will grow

at the nominal rate, and the bequest of $100,000 will grow at the

inflation rate.

B. Do the calculation again using real rates, and setting

inflation to equal 0. If you set up your Excel spreadsheet

carefully, you should be able to set the inflation rate to equal 0

and enter the real rate of return as the investment earning

rate.

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